Impact of Tax Reform on Real Estate
On 22 December 2017, the President signed tax reform legislation known as the Tax Cuts and Jobs Act (TCJA). Primarily known for reducing corporate tax rates to 21%, the TCJA had many impacts on the real estate industry, outlined below.
Tax Rate Changes, AMT, and Estate/Gift Tax. The TCJA lowered corporate income tax rates to a flat 21% and modified rates and brackets for non-corporate taxpayers such that the maximum non-corporate income tax rate is 37%. The additional 3.8% Medicare tax continues to apply. Capital gains rates were unchanged with the maximum rate remaining at 20%. The corporate alternative minimum tax (AMT) was eliminated, but AMT for individuals remains with only a temporary increase in the exemption thresholds through 2025. Although both the estate and gift tax were retained, there is a temporary increase in both exclusions through 2025 to USD 11.2 million (adjusted for inflation in 2018).
20% Rate Reduction for Non-Corporate Taxpayers. To provide some balance to the materially lower C corporation rates, new Section 199A provides non-corporate taxpayers with a potential 20% "deduction" against taxable income, which, when applicable, effectively "discounts" the maximum 37% non-corporate rate to 29.6%. This 20% discount takes the form of a complicated formulaic deduction generally equal to: (1) 20% of newly defined "qualified business income" plus (2) 20% of the sum of (a) REIT dividends and (b) publicly traded partnership income. For taxpayers with income over certain minimal thresholds, the 20% of qualified business income deduction is limited to the greater of: (a) 50% of the W-2 wages paid by the qualified business, or (b) 25% of the W-2 wages paid by the qualified business, plus 2.5% of the unadjusted basis of depreciable property held by the business (using the longer tax life of 10 years or the applicable non-ADS Section 168 life). These limitations are calculated at the individual level and the statutory language indicates that the limitation is to be applied separately for each "qualified trade or business" that the taxpayer is engaged in. There is not currently any guidance on whether or how multiple businesses or investments may be aggregated for purposes of this rule. There is a specific carve out for most service businesses, such as law and accounting firms, although engineering and architecture firms specifically retained the benefit of the deduction. For a REIT owner and a typical non-dealer real estate developer, this 20% deduction means that the maximum effective rate on ordinary income is now 29.6% before the potential 3.8% Medicare tax, while capital gains and Section 1231 gains will continue to benefit from the maximum 20% marginal capital gain rate.
Business Interest Deduction Limitations. The historical "interest stripping" limitations have been expanded materially and are no longer limited to related-party interest with debt ratios over 60%. Now all business interest expense deductions for taxpayers over a certain size are capped at 30% of EBITDA (EBIT beginning in 2022). However, a significant exception allows a "real property" business to elect out of the limitation, at the cost of applying longer ADS depreciation lives to qualified improvements, residential, and office properties (increasing their respective lives from 15, 27.5, and 39 years to 20, 30, and 40 years). This limitation applies at the entity (JV/REIT) level, with unlimited carry forwards at the entity level. There is no guidance on what happens to pre-2018 interest deductions that were suspended under the old Section 163(j) rules, although because the pre-2018 rules simply treated disallowed interest as paid in the next year, arguably any pre-2018 suspended interest would simply be subject to the new EBITDA limitations in 2018. There is also no guidance on how the real estate exception applies to debt incurred at a level above where the property is held (e.g., blocker debt), although guidance is expected soon with one possible approach being to apply the historic Section 1.163-8T interest tracing rules.
Net Operating Loss (NOL) and Active Loss Limitations. NOLs arising in 2018 and future years are no longer eligible to be carried back to prior tax years and are also now only usable against 80% of a future year's taxable income. Moreover, newly revised Section 461(l) prohibits a taxpayer, such as a real estate professional, from using net business losses over a threshold amount against non-business income, such as interest and dividends, with any excess treated as an NOL in the subsequent taxable year. This has the effect of materially reducing the value of excess losses and impacts the decision of whether to do a cost segregation study, because such a study may potentially create limited-use deductions and NOLs. Any NOLs from 2017 or prior years are not subject to this new 80% limitation and will be available to fully offset income (subject to potential limitation where the AMT applies).
Cost Recovery/Bonus Depreciation. The 27.5 and 39 year depreciable lives for residential and non-residential rental property were unchanged. The complex rules for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property have been combined and simplified into a permanent 15-year life for newly defined "qualified improvement property," which means any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. If a taxpayer elects out of the interest stripping limitations, the 20, 30, and 40 year ADS lives override the 15, 27.5, and 39 year lives, respectively. For property with tax lives of 20 years or less that are not subject to ADS depreciation, a taxpayer can elect 100% "bonus depreciation" for 2018 through 2022. Because of the NOL and loss limitations described above, taxpayers should carefully consider whether to make the bonus depreciation election as it frequently will not be optimal to do so.
Carried Interests. In a greatly abbreviated version of prior carried interest proposals, new Section 1061 now requires a 3-year holding period for a "carried interest" partner to receive the benefit of the long-term capital gains rate. Unlike prior legislative proposals, this law does not recast a carried interest as ordinary compensation income but instead limits what qualifies as long term for capital gain purposes. If the legislation also applies to Section 1231 property (which is not certain and potentially not the case), if a rental property is sold more than 1 year but less than 3 years after it is placed in service the general partner's carried interest share is re-characterized as short-term capital gain (taxed at ordinary income rates), while the return to capital investors remains as long-term capital gain. The details of this new rule are complex and vague, but include concepts such as recasts for interests transferred to related persons and exemptions for carried interest held by a corporation and for a service partner's non-carried interest capital investment. This new rule appears to have a primary focus on investment funds, but has likely application to all GP "promotes" where capital raising is done on a "regular, continuous, and substantial basis" (unless and until the IRS exercises its authority to limit the scope to more traditional portfolio investment funds).
Like-Kind Exchanges. Section 1031 like-kind exchanges continue to be available for real property not held primarily for sale, but are eliminated for all other property. This was a major win for the real estate industry, but the real estate limitation means that there is more pressure to classify an asset as real property and more complication if a portion of a building is not treated as real estate under a cost segregation study (although the latter could benefit from 100% expensing of certain components of the replacement asset).
Impact on REITs. Overall the rules are unchanged for REITs, although REITs will benefit from the lower 21% corporate tax rate to the extent the REIT pays tax through a Taxable REIT Subsidiary or does not distribute 100% of its taxable income. Further, REIT ordinary dividends automatically qualify for the new Section 199A 20% qualified business income deduction, effectively lowering the maximum tax rate on such dividends from 37% to 29.6% without the potential W-2/tax basis limitations that generally apply under Section 199A. For individual investors, REIT capital gain dividends continue to receive the capital gain rate preference. One open question is whether future guidance will carry the Section 199A deduction for REIT dividends that are earned indirectly through a RIC (mutual fund).
Impact on International Investors. For non-US investors that invest through a C corporation "blocker", the lowering of corporate rates to a flat 21% materially reduces the tax leakage incurred in such blocker structures. However, it would be helpful for the government to confirm that a blocker is considered as being engaged in the real property business of a lower-tier property holding entity for purposes of electing out of the new Section 163(j) interest stripping rules. If a blocker does not elect out of the new interest stripping rules, it could materially increase the taxable income of the blocker and could push the blocker to use less leverage. The tax consequences for non-US investors that invest through REITs was largely unchanged beyond the discussion above under "Impact on REITs." For individual non-US investors, the temporary Section 199A 20% qualified business income deduction may provide an incentive in particular contexts to invest in U.S. real estate "unblocked" to take advantage of the lower effective tax rates on ordinary income. Non-US investors should also consider the impact of various new complex "base erosion" limitations, such as new Section 267A which limits deductions for payments by or to a hybrid entity and pursuant to a hybrid transaction.
Taxation of Governmental Grants. The TCJA materially limited the Section 118 income exclusion for corporations to be able to receive certain state and local subsidies on a tax-free basis, including contributions in aid of construction and contributions from a governmental entity or civic group. For example, the legislative history clarifies that a contribution of land by a municipality would be taxable, whereas a municipal tax abatement would not. This provision applies to contributions after 22 December 2017, with a grandfathering exclusion for contributions as part of a pre-existing approved master development plan. The legislative history confirms that to the extent Section 118 continues to apply, it is limited to corporations (i.e., it does not apply to partnerships). This change materially impacts municipalities who provide such grants, and future structuring of such arrangements should be modified to account for this change.
Other Changes Impacting Real Estate.
- The 20% tax credit for the rehabilitation of historically certified structures is preserved, but taxpayers must claim the credit ratably over a 5-year period and the legislation repeals the 10% credit for the rehabilitation of pre-1936 structures.
- There is a new limit on the annual deductibility of individual state and local taxes to no more than USD 10,000. State and local taxes paid or accrued in carrying on a trade or business remain deductible; however, for individuals, state and local taxes that are considered incurred in an activity related to the production of income (i.e. Section 212 deductions) are not deductible from 2018 through 2025 due to the suspension of the allowance of miscellaneous itemized deductions.
- The TCJA provides that a taxpayer may treat no more than USD 750,000 as debt eligible for the home mortgage interest deduction (USD 1 million in the case of debt incurred before 15 December 2017). This limitation applies to the aggregate debt for a primary and second home. Beginning in 2018, the legislation eliminates the deduction for interest paid on a home equity loan, including existing home equity loans.
- Starting in 2018, partnership "technical terminations" are eliminated. Thus a sale or exchange of 50% or more of the interest in a partnership in a 12-month period will no longer restart Section 168 depreciation lives. This change also creates some uncertainty for states that “piggy back” off of the technical termination rules for determining whether transfer taxes are due. There was also a minor change expanding when a mandatory inside basis reduction applies to loss assets upon the transfer of a partnership interest.
- There are new temporary income tax deferrals and exclusions through 2026 for certain investments in designated qualified opportunity zones involving low-income communities.
Unchanged Items. Other items that were at risk but ultimately unchanged (for now) include low-income housing tax credits, new market tax credits, private activity bond and stadium financing bond interest exclusions, and the exclusion for gains on personal residence sales. Further, the proposed special interest limitations for an international financial reporting group and the proposed unrelated business income tax for governmental pension plans were ultimately not included in the final legislation.
Tax Planning. The TCJA dramatically altered the tax landscape and its enactment was incredibly rushed. As a result, much of these new tax rules are complex and vague, with stark dichotomies in tax consequences, and many potential pitfalls and opportunities. Taxpayers should carefully re-evaluate all of their existing structures as well as carefully considering the tax aspects of future transactions.